Last year will likely go down in the record books as being the most important in the history of the legal cannabis movement. By the time the curtain closed on 2018, Canada had legalized recreational marijuana, a handful of additional U.S. states had given marijuana the green light in some capacity, and the U.S. farm bill had been signed by President Trump, thereby legalizing hemp and hemp-based cannabidiol. The legal cannabis industry gained validity like never before and became a legitimate business model for investors.
Yet it turned out to be a terrible year for most marijuana stocks. Following two years of incredible gains, most investors were treated to double-digit percentage losses. Of course, this wasn't the case for the largest marijuana stock by market cap, Canopy Growth (NYSE:CGC). Through this past weekend, shares of Canopy Growth were up nearly 6% in 2018, bucking the trend that swept through the industry.
The big question is: Does Canopy Growth belong in your portfolio in 2019? Let's take a closer look at both sides of the argument.
Here's why the largest publicly traded pot stock belongs in your portfolio
The first and most obvious reason to believe in the Canopy Growth story is Constellation Brands' (NYSE:STZ) $4 billion equity investment in the company, which was announced in mid-August and closed in November. This actually marked the third time since October 2017 that Constellation had made a direct or indirect (e.g., the purchase of convertible bonds) investment into Canopy Growth, and it pushed the company's ownership stake up to 37%.
There's a lot to like about this combination. To begin with, Constellation Brands will be bringing its deep pockets and marketing expertise to the table in an effort to get Canopy's product into new markets. And let's not forget that Constellation Brands also received 139.7 million warrants with its equity investment that, if exercised, could boost its equity stake up to 56%. This suggests that Canopy Growth may very well be an acquisition target for Constellation Brands within the next couple of years. If that's the case, the assumption is we'd see a healthy premium over Canopy's current valuation, if acquired.
As for Canopy Growth, it now has around $4.3 billion in cash on hand to work with. That's more than enough to complete its capacity expansion projects, build up its existing product line, develop new products, expand into international markets, and acquire complementary businesses. In essence, this cash sets a healthy foundation under Canopy's current market cap of nearly $10 billion.
Investors should also like the company's production potential. According to management, Canopy Growth is aiming for 5.6 million square feet of licensed capacity that could produce (by my estimate) 500,000 kilograms at peak yield. This would make Canopy the second-largest producer by annual volume, and it would also likely make the grower a go-to for Canadian provinces and overseas countries looking to secure long-term supply commitments. It already has around 70,000 kilograms in annual commitments secured from Canadian provinces.
The company's infrastructure and sales channels are also unrivaled. Canopy Growth owns what's arguably the most recognized cannabis brand in the country (Tweed), and has numerous means of reaching consumers, whether through owned retail locations or online sales channels.
And here's why you should think twice before adding Canopy Growth
Of course, there are two sides to this story.
The biggest reason to think twice about buying Canopy Growth is its bottom line. There's absolutely no question that it and its peers will deliver triple-digit sales growth in 2019, and perhaps even 2020, as production comes online. The issue with Canopy Growth is that it'll be spending so much on building up its brands, expanding into new markets, completing its greenhouses, and making acquisitions that it won't have any chance to turn a profit in 2019. Since marijuana is legal in Canada, earnings actually matter now -- and this company is on track to turn in one ugly year from a fundamental perspective.
The pot shortage in Canada is another reason you might be better off staying on the sidelines. Even though Canopy Growth has 4.3 million of its 5.6 million square feet licensed by Health Canada, the company could still become a victim of the regulatory red tape that's stymied supply. It's taken close to a year, on average, for growers to get approved for a sales permit from Health Canada, with cultivation licensing often taking many months. The result has been supply shortages in more than half of all Canadian provinces. These shortages could drive consumers back to the black market, which can easily undercut legal sales channels on price and don't have licenses or permits to wait for.
To add to this point, Canopy Growth does have an impressive inventory that's designed to ensure it doesn't run out of supply. The problem is that it hasn't been selling its full complement of cannabis strains online, which is why it still has a reasonable inventory level. In doing so, Canopy Growth's lack of near-term product diversity could wind up costing it an opportunity to secure loyal customers over the long run.
A final point worth noting is that Canopy's production ramp-up, and really that of the entire industry, is going to take time. Sure, 500,000 kilograms on an annual basis will be impressive. But the fact remains that Canopy Growth is probably a few years away from reaching this mark. Unforeseen delays (e.g., regulatory red tape) could mean that Wall Street's sales forecasts are too aggressive.
As you can see, there are a few very good reasons to buy shares of this industry leader, and quite a few reasons to keep your distance. So what's an investor to do?
With Canopy Growth having given up all of the premium it received following the Constellation Brands' deal announcement, I personally view the company as fairly valued right now.
Canopy's core advantages -- such as its superior sales channels, branding, and its new-found investor (Constellation Brands) -- should give it excellent reach into new markets. The company should have no trouble growing sales at a rapid pace, and it has a huge cash pile with which to execute its corporate strategy.
The problem is -- and this is the reason I'd suggest adding Canopy Growth to your watch list rather than your portfolio -- this company won't be profitable for at least another year. As long as the stock market is in the midst of a correction, operating results are going to matter. No longer will Wall Street turn a blind eye to big losses that are masked with promises of success. Even though I do feel that Canopy Growth could become substantially profitable by the early to mid-2020s, it's yet to demonstrate that recurring profitability on an operating basis to Wall Street. Until that happens, the sideline is the safest place to be.